Since the reunification with the Mainland China, the economic growth of Hong Kong has followed a "W" pattern. However, disregarding the high growth around year 2000 caused by the "high tech bubble", a "U" shape growth pattern can be identified. During the first six years (1998-2003), the economy of Hong Kong was gloomy with the annual average growth rate 2.4%. From 2004 to 2006, it rebounded strongly to 7.6%. In 2007, growth momentum, though persists, has slowed somewhat, with the first quarter GDP growth preliminarily estimated to be 5.6%. Annual growth in 2007 is now forecast to fall below last year's 6.8%.

Hong Kong experienced historic difficult times in the first six years after the reunification with the Mainland China:

1. The stock market suffered a 60% decline during the first year after the reunification while residential property prices tumbled by 65% in six years' time. 
2. The economy went into a double-dip recession¹, mainly in private consumption and investment in building and construction. In 1998, the economy experienced a negative growth of 5.5% - the first economic contraction recorded since the compilation of official statistics in the 1960s.
3. A large number of "middle class" households fell into negative equity after the drastic decline of residential property prices. The number of such cases reached 110,000 by mid 2003.
4. An up to 68-month deflation from November 1998 to June 2004. Measured by the GDP deflator, prices fell by 24.5% in total or 3.6% each year in average in the eight years starting from 1999².
5. Most of the salaried class suffered pay-cut or pay-freeze for about a decade.
6. The unemployment situation worsened, with the quarterly unemployment rate and the number of unemployed reaching 8.5% and 310,000 by Q1 2003³.
7. Fiscal deficits were incurred for six years from 1998 to 2004 and fiscal reserves depleted from HKD457.5 billion (equivalent to 28 months' government expenditure) in March 1998 to HKD275.3 billion (equivalent to 14 months' government expenditure) in March 2004⁴.

Quite a number of factors have led to the various problems after the reunification.

1. As economy had operated under a "three high" (high wages, high land prices and high inflation rates) state for long time before 1997, Hong Kong has gradually developed a "bubble economy", pressure to adjust emerged.
2. Successive attacks from the financial crisis, global economic downturn and SARS further aggravated the situation.
3. A structure change in economic role as a "middleman" motivated by the acceleration of China's reform and opening-up.
4. Under a linkage exchange rate system, Hong Kong is unable to depreciate its currency as its desire; the burden of economic adjustment mainly fell on the asset market, wages and general prices, prolonging the adjustment process. Hong Kong's economy, nevertheless, was supported by fairly strong external demand during 1998-2003. Despite the negative growth rates recorded in 1998 and 2001, the average annual growth rates for overall exports and services exports still reached 6% and 7.1% respectively.

After enduring the attack by speculators, Hong Kong gradually recovered with the support of the Central Government⁵. The most crucial factor that fostered Hong Kong's recovery should be the signing of Closer Economic Partnership Arrangement (CEPA) between the Central Government and the Hong Kong SAR Government.

With the signing of CEPA, investors saw the opportunity for Hong Kong to extend its hinterland to the whole of China, favourable for economic restructuring. The stock market was the first to respond, with the Hang Seng Index gradually rebounding from the trough in mid 2003. In September 2006, the Index broke the record high set in March 2000 and by June 2007, it reached a new high at 21,999.9, representing a 1.6 times increase from the trough recorded in April 2003. The property market followed, with residential property prices rebounded by 60% in one and a half years. Compared with September 2003, prices for residential properties and offices registered 70% and 170% increases respectively.

The Hong Kong economy recovered accordingly, registering an annual average growth of 7.6% during 2004-2006, tripling the pace in 1998-2003 and was also higher than the average of the previous decade (1987-1996) at 6%. The average growth for the past decade was also lifted to 4.2%.

Exports and private investment were the major drivers of the recent recovery since 2004. Average annual growth for exports of goods and services in 2004-06 reached 12.2% and 12.6% respectively, while growth of investment in private machinery, equipment and software for the period reached 15.2%. However, public investment and consumption as well as overall building and construction continued to decline, which implied that the low base had a certain contribution on the strong economic rebounds in the past three years.

Favourable developments followed the economic rebound since 2004.

1. The budget situation turned around from deficits to surplus in 05/06, although the narrow tax base remained unresolved.
2. Rapid expansion in the financial sector was propelled by increased stock market turnover and corporate financing needs. Hong Kong has emerged as the largest external financial market serving Mainland China.
3. The adjustment in property prices, rent and wages has helped strengthen Hong Kong's role as an operating centre. By 2006, overseas companies operating in Hong Kong reached 6,354, increasing by 52% from 1997. Specifically, regional headquarters increased by 33% to 1,228 and regional offices increased by 62% to 2,617⁶.
4. Hong Kong regained the 3rd position in terms of competitiveness in the world⁷.

In 2007, the Hong Kong economy continued to grow. Compared with the past three years, domestic demand further strengthened while external demand maintained high growth, creating a more balanced growth structure. In the first quarter, domestic demand increased by 5.1%, higher than the average of 4.3% in 2004-06. Private consumption, being the major domestic demand component, grew by 5.6% in the quarter. Investment, on the other hand, performed less satisfactorily, growing only by 3.9%. As to external demand, it grew by 8.2%, with export of services growing by 8.4%, faster than exports of goods. Another bright spot appeared in the labour market, with the Q1 unemployment rate falling to 4.3%, being the lowest in ten years.

This year's growth momentum has slowed, nonetheless. GDP growth at 5.6% in the first quarter was the lowest quarterly growth rate since 2004. The slowdown can be attributable to the higher base-year figure as well as the still sluggish building and construction sector.

II. 2007 and Medium-term Outlook

Favourable factors should continue to support the Hong Kong economy in the second half-year. External factors include

(1) persistent rapid growth in the Mainland; (2) favourable economic situation in Japan and the E.U. and (3) the weak dollar and continued high growth in China's external trade. Internal factors include (1) active financial markets; (2) falling unemployment rate and (3) Pay raised in both the public and private sectors in the circumstances of remarkable corporate profits and public finance surplus. Private consumption should be well supported. Moreover, improving property transactions and more active participation in land sale by developers should help foster the still sluggish building and construction investment.

Nevertheless, a number of uncertainties should not be overlooked. (1) The U.S. economy and property markets would probably be weaker-than-expected this year, as suggested by the low Q1 economic growth rate of 0.6%, with annual growth forecast revised to 2-2.5%. (2) Japan, the U.K. and the Euro Area recorded satisfactory economic growth and inflationary pressure was also seen in rising import prices and production costs, having prompted central banks to hike rates this year. As food prices rise and soaring stock and property prices may induce fears of asset bubbles, China may possibly raise interest rates further. For the U.S., the chance of a rate cut this year is now much lowered due to the wary of inflation. (3) Also, risks have mounted in major stock markets as prices set record highs successively.

Taking into consideration the above factors, Hong Kong's economic momentum remains rock-solid, however, the economic growth rate is expected to slowdown because of the higher year base, we maintain the 2007 forecast at 5%.
 
As for inflation, rising food prices from the Mainland has added pressure on domestic prices. Yet, the SAR government's various preferential measures, including waiver of rates for two quarters, rent reduction for public estates and support for kindergarten in the form of teaching vouchers. These would contribute to contain price rises. Hence, annual inflation is forecast to remain steady at 2%, the same increase as last year.

Looking into the medium term, Hong Kong's growth momentum will rely on the progress of economic transformation. As Hong Kong's service sector has already expanded to occupy 91% of the overall economy, its development towards a cosmopolitan like London or New York seems irreversible. The favourable outcome counts much on a proper population policy and better education system to break through the talent bottleneck, in addition, the innovation capability on finance and applied science also need to be enhanced in order to strengthen HK's position as an Asia leading international financial centre and international city. Having institutional and location advantages, we are confidential that Hong Kong would enable to reshape its professional roles and leverage its professional advantages to better service the needs of China's economic development, then keeps the energy in its economic growth.

Hong Kong Real Gross Domestic Product Forecasts (%)